Week in Review

Money is a temporary storage of value. We created money to make trade easier. We once bartered. We looked for people to trade with. But trying to find someone with something you wanted (say, a bottle of wine) that wanted what you had (say olive oil) could take a lot of time. Time that could be better spent making wine or olive oil. So the longer it took to search to find someone to trade with the more it cost in lost wine and olive oil production. Which is why we call this looking for people to trade goods with ‘search costs’.

Money changed that. Winemakers could sell their wine for money. And take that money to the supermarket and buy olive oil. And the olive oil maker could do likewise. Greatly increasing the efficiency of the market. There is a very important point here. Money facilitated trade between people who created value. Creating something of value is key. Because if people were just given money without producing anything of value they couldn’t trade that money for anything. For if people didn’t create things of value to buy what good was that money?

Today, thanks to Keynesian economics, governments everywhere believe they can create economic activity with money. And use their monetary powers to try and manipulate things in the economy to favor them. And one of their favorite things to do is to devalue their money. Make it worth less. So governments that borrow a lot of money can repay that money later with devalued money. Money that is worth less. So they are in effect paying back less than they borrowed. And governments love doing that. Of course, people who loan money are none too keen with this. Because they are getting less back than they loaned out originally. And there is another reason why governments love to devalue their money. Especially if they have a large export economy.

Before anyone can buy from another country they have to exchange their money first. And the more money they get in exchange the more they can buy from the exporting country. This is the same reason why you can enjoy a five-star vacation in a tropical resort in some foreign country for about $25. I’m exaggerating here but the point is that if you vacation in a country with a very devalued currency your money will buy a lot there. But the problem with making your exports cheap by devaluing your currency is that it has a down side. For a country to buy imports they, too, first have to exchange their currency. And when they exchange it for a much stronger currency it takes a lot more of it to buy those imports. Which is why when you devalue your currency you raise prices. Because it takes more of a devalued currency to buy things that a stronger currency can buy. Something the good people in Japan are currently experiencing under Abenomics (see Japan Risks Public Souring on Abenomics as Prices Surge by Toru Fujioka and Masahiro Hidaka posted 4/14/2014 on Bloomberg).

Prime Minister Shinzo Abe’s bid to vault Japan out of 15 years of deflation risks losing public support by spurring too much inflation too quickly as companies add extra price increases to this month’s sales-tax bump.

Businesses from Suntory Beverage and Food Ltd. to beef bowl chain Yoshinoya Holdings Co. have raised costs more than the 3 percentage point levy increase. This month’s inflation rate could be 3.5 percent, the fastest since 1982, according to Yoshiki Shinke, the most accurate forecaster of Japan’s economy for two years running in data compiled by Bloomberg…

“Households are already seeing their real incomes eroding and it will get worse with faster inflation,” said Taro Saito, director of economic research at NLI Research Institute, who says he’s seen prices of Chinese food and coffee rising more than the sales levy. “Consumer spending will weaken and a rebound in the economy will lack strength, putting Abe in a difficult position…”

Abe’s attack on deflation — spearheaded by unprecedented easing by the central bank — has helped weaken the yen by 23 percent against the dollar over the past year and a half, boosting the cost of imported goods and energy for Japanese companies.

Japan is an island nation with few raw materials. They have to import a lot. Including much of their energy. Especially since shutting down their nuclear reactors. Japan has a lot of manufacturing. But that manufacturing needs raw materials. And energy. Which are more costly with a devalued yen. Increasing their costs. Which they, of course, have to pay for when they sell their products. So their higher costs increase the prices their customers pay. Leaving the people of Japan with less money to buy their other household goods that are also rising in price. Which is why economies with high rates of inflation go into recession. As the recession will correct those high prices. With, of course, deflation.

Keynesians all think they can manipulate the market place to their favor by playing with monetary policy. But they are losing sight of a fundamental concept in a free market economy. Money doesn’t have value. It only holds value temporarily. It’s the things the factories produce that have value. And whenever you make it more difficult (i.e., raise their costs by devaluing the currency) for them to create value they will create less value. And the economy as a whole will suffer.

Week in Review

In the Eighties Japan Inc. was going strong. The Japanese economy roared. And the Nikkei soared. The Japanese had more money than they knew what to do with it. So they started buying U.S. assets. People feared that Japan would one day own America. And urged that we had to follow their lead before it was too late. The American government should partner with business like in Japan. So smart bureaucrats could maximize economic output. Instead of leaving it to inefficient market forces.

But Japan Inc. was state capitalism at its worse. Instead of letting the market determine the allocations of scarce resources that have alternate uses the government stepped in with their crony capitalist friends. Leading to corruption. And a lot of malinvestments. Money invested poorly. Causing great asset bubbles. That burst in the Nineties. Where Japan Inc. was replaced by the Lost Decade. A decade or more of deflation. To wring out all the inflation the government fueled with their artificially low interest rates that caused all of that malinvestment. And those asset bubbles. If you’re too young to have lived during this you can still see it in action. This time in the United States (see The U.S. looks like Japan: Investors rejoice by Paul R. La Monica posted 5/16/2013 on CNNMoney).

The U.S. economy is still not close to being fully recovered from the Great Recession, but investors could give a mouse’s posterior about this sad fact…

…Consumer prices fell for the second straight month. The absence of runaway inflation is of course a good thing, especially when you consider that the Federal Reserve has pumped an inordinate amount of money into the system with its asset purchase programs. But if prices continue to dip, that’s a big problem. Deflation is much worse than mild inflation. Just ask Japan.

Ah yes, Japan! It has taken steps to combat deflation with a vengeance this year. The Bank of Japan’s stimulus, dubbed Abenomics in honor of the country’s prime minister, is like the Fed’s quantitative easing…on steroids.

There’s the rub. The longer that the U.S. stays in tepid growth mode — what I’ve been calling the “low and slow barbecue recovery” since 2010 — the comparisons to Japan will only increase. After all, the U.S. also has an aging population and a large government debt load. The Great Recession ended in June 2009 and here we are in May 2013 still with a lackluster recovery. So we’re almost halfway to our own Lost Decade…

The problem here is Keynesian economics. It was Keynesian economics that got Japan into the mess they’re in by playing with interest rates to stimulate artificial economic activity. But Keynesians are like drunks. They think a little hair of the dog can cure their hangover. So they binge again on artificially low interest rates to create more artificial economic activity. Which will end the same way. As it ended in the Nineties. A long painful deflation to wring out all of that inflation they pumped into the economy. Just as the Americans will go through. Because Keynesians dominate their monetary policy, too.

Even though there are many smart people, including members of the Fed, who are worried that QE ∞ will eventually cause a huge inflation headache and create more nasty asset bubbles down the road, the market doesn’t expect the Fed to pull back on its easing anytime soon…

That’s why stocks could keep climbing. It doesn’t matter that the economy is not healthy enough to make most average consumers feel better. Wall Street only cares about the Fed.

This can’t last forever, of course. Sooner or later, the economy is either going to slow so much that we have to start worrying about another recession (and no amount of stimulus will help prevent a market pullback if that happens) or the economy will start showing signs of a legitimate, sustainable and robust recovery. In that latter case, the Fed will have no choice but to end QE and start raising interest rates.

But for now, at least, investors can enjoy the fact that the United States is basically morphing into Japan Lite. Who cares about the health of the economy as long as central banks keep those printing presses running 24/7/365? Joy.

The selling point of Keynesian economics was eliminating the recessionary side of the business cycle. So it is interesting that some of our worse recessions have been in the era of Keynesian economics. I mean, that’s what the New Deal was. Keynesian. And what did it give us? The Great Depression. Why? Why are the recessions so painful in the era when they were supposed to be less painful? Because all Keynesian economics does is to delay economic corrections. By delaying the onset of recessions. And because it delays the correction it allows a bubble to grow greater. So when the correction comes prices have farther to fall. Which makes a recovery in the Keynesian era more drawn out. And more painful. Unless you like your recessions to last a decade. Or more.

So while Main Street America continues to suffer under President Obama’s Keynesian policies Wall Street is doing just fine. As rich people always do when partnering with government. Only Main Street suffers the fallout of their Lost Decades.

Week in Review

Investors like rising stock prices. They don’t like falling stock prices. Which is why Wall Street likes inflation. And fear deflation. Even though the economy is still sluggish with more and more people dropping out of the labor market (which is why the unemployment rate fell) investors are bullish. Because of the Federal Reserve and all of their quantitative easing.

The more the Fed increases the money supply the more inflation there will be. Investors like that. Because inflation increases prices. Such as the prices of their stocks. As well as gasoline and groceries. Making the current economic times odd. For the stock market recently reached a record high. Even though the labor participation rate (see THE EMPLOYMENT SITUATION —FEBRUARY 2013, page 4) continues to fall. It is now at 63.5%. Which means 89,304,000 people are not in the labor force. A record high. But you wouldn’t know this by looking at the official unemployment rate. Or the stock market (see Stocks And Inflation: The End Of An (Abnormal) Affair? by James Picerno posted 3/69/2013 on Seeking Alpha).

The positive correlation between the market’s inflation forecast and the stock prices appears a bit looser these days, but it’s premature to declare that the link has been broken…

Normally, rising/high inflation doesn’t inspire the bulls. But the last several years have been less than normal in terms of the macro backdrop. The crowd has remained worried about disinflation/deflation, which means that signs of higher inflation in the future have soothed anxious traders…

And why not? For when have inflationary policies ever caused an asset bubble? That burst into a long and painful recession? Except the housing bubble that brought about the 1990-91 recession. The dot-com bubble that brought about the 2000-01 recession. And that other housing bubble that brought about the 2007-09 recession. AKA The Great Recession. So there is no worry that these record highs in stock prices aren’t just another bubble. Just waiting to burst. Bringing on another deflationary recession. I mean, what are the odds of that happening again?

Actually, the chances are pretty good that 2013 will have a very painful recession. Because we don’t have any real economic growth. These gains in the stock market aren’t because businesses are expanding and hiring. Not with a falling labor participation rate. No. For all intents and purposes we are still in the 2007-09 recession. Only we should probably call it the 2007-(end date to be determined) recession. Because the president’s economic policies haven’t helped the economy yet. And probably never will.

There’s no reason to believe that the fifth year will be any better than the previous four years. In fact, it will probably be worse. In fact one would almost get the impression that he is not trying to help the economy. But, instead, trying to destroy the Republican Party. So he can win the House of Representatives back in 2014. So he can pass even more anti-business policies. To transform the country into something it was never before. Less prosperous than communist China.

Week in Review

In the Eighties Japan kept interest rates artificially low. Creating a lot of artificial economic activity. Businesses borrowed money because it was cheap. And banks loaned money because there was so much of it to loan. Unfortunately, this led to a bubble. A big one. Asset prices soared. And when that bubble burst those prices fell back to earth like a rock. Sending the Japanese economy free falling into a deflationary spiral as it tried to wring out all of that inflation from those low interest rates. And some 30 years later they’re still suffering from the affects of that deflation (see G20 defuses talk of “currency war”, no accord on debt by Randall Palmer and Lidia Kelly posted 2/16/2013 on Reuters).

Japan’s expansive policies, which have driven down the yen, escaped direct criticism in a statement thrashed out in Moscow by policymakers from the G20, which spans developed and emerging markets and accounts for 90 percent of the world economy.

Analysts said the yen, which has dropped 20 percent as a result of aggressive monetary and fiscal policies to reflate the Japanese economy, may now continue to fall.

“The market will take the G20 statement as an approval for what it has been doing — selling of the yen,” said Neil Mellor, currency strategist at Bank of New York Mellon in London. “No censure of Japan means they will be off to the money printing presses.”

This is how they got into so much trouble in the first place. This is why they have a Lost Decade in Japan. Because of those low interest rates that blew up great asset bubbles. That burst. Sending prices into a freefall. A little hair of the dog that bit you MAY alleviate the discomforts of a hangover. But when that dog is a 150-pound French Mastiff with your throat in its mouth you’d be better off finding another cure for your inflationary hangover. For nothing good can possibly come from another round of inflation that will only create more asset bubbles. Their Lost Decade turned into Lost Decades because they kept trying to fix things before the market undid all their previous fixing. As painful as it may be they need to let the market complete its correction. Had they let the market do this in the Nineties the pain would be over with. And they would be enjoying real economic growth today.

Economics 101

In the Barter System we Traded our Goods and Services for the Goods and Services of Others

Money. It’s not what most people think it is. It’s not what most politicians think it is. Or their Keynesian economists. They think it’s wealth. That it has value. But it doesn’t. It is a temporary storage of value. A medium of exchange. And that alone. Something that we created to make economic trades easier and more efficient. And it’s those things we trade that have value. The things that actually make wealth. Not the money we trade for these things.

In our first economic exchanges there was no money. Yet there were economic exchanges. Of goods and services. That’s right, there was economic activity before money. People with talent (i.e., human capital) made things, grew things or did things. They traded this talent with the talent of other people. Other people with human capital. Who made things, grew things or did things. Who sought each other out. To trade their goods and services for the goods and services of others. Which you could only do if you had talent yourself.

This is the barter system. Trading goods and services for goods and services. Without using money. Which meant you only had what you could do for yourself. And the things you could trade for. If you could find people that wanted what you had. Which was the great drawback of the barter system. The search costs. The time and effort it took to find the people who had what you wanted. And who wanted what you had. It proved to be such an inefficient way to make economic transactions that they needed to come up with a better way. And they did.

The Larger the Wheat Crop the Greater the Inflation and the Higher the Prices paid in Wheat

They found something to temporarily hold the value of their goods and services. Money. Something that held value long enough for people to trade their goods and services for it. Which they then traded for the goods and services they wanted. Greatly decreasing search costs. Because you didn’t have to find someone who had what you wanted while having what they wanted. You just had to take a sack of wheat (or something else that was valuable that other people would want) to market. When you found what you wanted you simply paid an amount of wheat for what you wanted to buy. Saving valuable time that you could put to better use. Producing the goods or services your particular talent provided.

Using wheat for money is an example of commodity money. Something that has intrinsic value. You could use it as money and trade it for other goods and services. Or you could use it to make bread. Which is what gives it intrinsic value. Everyone needs to eat. And bread being the staple of life wheat was very, very valuable. For back then famine was a real thing. While living through the winter was not a sure thing. So the value of wheat was life itself. The more you had the less likely you would starve to death. Especially after a bad growing season. When those with wheat could trade it for a lot of other stuff. But if it was a year with a bumper crop, well, that was another story.

If farmers flood the market with wheat because of an exceptional growing season then the value for each sack of wheat isn’t worth as much as it used to be. Because there is just so much of it around. Losing some of its intrinsic value. Meaning that it won’t trade for as much as it once did. The price of wheat falls. As well as the value of money. In other words, the bumper crop of wheat depreciated the value of wheat. That is, the inflation of the wheat supply depreciated the value of the commodity money (wheat). If the wheat crop was twice as large it would lose half of its value. Such that it would take two sacks of wheat to buy what one sack once bought. So the larger the wheat crop the greater the inflation and the higher the prices (except for wheat, of course). On the other hand if a fire wipes out a civilization’s granary it will contract the wheat supply. Making it more valuable (because there is less of it around). Causing prices to fall (except for wheat, of course). The greater the contraction (or deflation) of the wheat supply the greater the appreciation of the commodity money (wheat). And the greater prices fall. Because a little of it can buy a lot more than it once did.

Creating a bumper crop of wheat is not easy. Unlike printing fiat money. It takes a lot of work to plow the additional acreage. It takes additional seed. Sowing. Weeding. Etc. Which is why commodity money works so well. Whether it’s growing wheat. Or mining a precious metal like gold. It is not easy or cheap to inflate. Unlike printing fiat money. Which is why people were so willing to accept it for payment. For it was a relative constant. They could accept it without fear of having to spend it quickly before it lost its value. This brought stability to the markets. And let the automatic price system match supply to the demand of goods and services. If things were in high demand they would command a high price. That high price would encourage others to bring more of those things to market. If things were not in high demand their prices would fall. And fewer people would bring them to market. When supply equaled demand the market was in equilibrium.

Prices provide market signals. They tell suppliers what the market wants more of. And what the market wants less of. That is, if there is a stable money supply. Because this automatic price system doesn’t work so well during times of inflation. Why? Because during inflation prices rise. Providing a signal to suppliers. Only it’s a false signal. For it’s not demand raising prices. It’s a depreciated currency raising prices. Causing some suppliers to increase production even though there is no increase in demand. So they will expand production. Hire more people. And put more goods into the market place. That no one will buy. While inflation raises prices everywhere in the market. Increasing the cost of doing business. Which raises prices throughout the economy. Because consumers are paying higher prices they cannot buy as much as they once did. So all that new production ends up sitting in wholesale inventories. As inventories swell the wholesalers cut back their orders. And their suppliers, faced with falling orders, have to cut back. Laying off employees. And shuttering facilities. All because inflation sent false signals and disrupted market equilibrium.

This is something the Keynesians don’t understand. Or refuse to understand. They believe they can control the economy simply by continuously inflating the money supply. By just printing more fiat dollars. As if the value was in the money. And not the things (or services) of value we create with our human capital. Economic activity is not about buying things with money. It’s about using money to efficiently trade the things we make or do with our talent. Inflating the money supply doesn’t create new value. It just raises the price (in dollars) of our talents. Which is why Keynesian expansionary monetary policy has been such a failure. For their macroeconomic policies only disrupt normal market forces. Which result in a macroeconomic disequilibrium. Such as raising production in the face of falling demand. Because of false price signals caused by inflation. Which will only bring on an even more severe recession to restore that market equilibrium. And the longer they try to prevent this correction through inflationary actions the longer and more severe the recession will be.

History 101

FDR increased the Power of Labor Unions and allowed Big Corporations to Collude with Each Other

Those in mainstream economics (i.e., Keynesian economics) studied the Great Depression and determined that the problem was a lack of spending. Which is why they cheer FDR and his New Deal programs. Because the New Deal spent enormous amounts of money. And according to prevailing Keynesian thought that was all that was needed to end the Great Depression. Spending. And if the private sector wasn’t going to spend money then the government could. And the government’s spending could replace all that economic activity that disappeared when the private sector stopped spending. So the government spent. But in those 10 to 15 years they failed to pull the nation out of the Great Depression.

According to Keynesian thought, and John Maynard Keynes himself who visited FDR in the White House, the government needed to spend money. Even money they didn’t have. Keynes urged the president to deficit spend. To run huge deficits in the short term to kick-start the economy. Keynes showed that it was the only way with a lot of figures and math. FDR later said Keynes was more a mathematician than an economist. Still, FDR spent. But he did even more. Believing part of the reason for the lack of spending was the evils of capitalism. There was just too much competition keeping prices low. And businesses selling at low prices couldn’t pay high wages. Ergo to stimulate economic activity FDR wanted to increase the cost of doing business.

FDR increased the power of labor unions to help them negotiate higher wage packages. And he allowed big corporations to collude with each other so they could raise their prices so they could afford to pay those higher union wages. These two things really helped workers get better pay. Some 25% higher they otherwise would have had. This was a big win for labor. And for the socialists and communists in America who hated capitalism. (The 1930s were a time of nationalist, socialist, fascist and communist movements sweeping the world. And strong elements in the U.S. wanted to join these movements. The Soviet Union even had agents working inside the Roosevelt administration.) In fact, they were angry that FDR didn’t take this chance to deliver the deathblow to capitalism once and for all by nationalizing some big industries. Something FDR wasn’t willing to do.

FDR did Everything in his Power to Increase Wages & Prices because of the Massive Deflation of the Great Depression

Then came the alphabet soup of make-work agencies. Civilian Conservation Corps (CCC) paid young unemployed men to do landscaping and other outdoor activities. Tennessee Valley Authority (TVA) paid young men to build dams and other water related activities. Agricultural Adjustment Act (AAA) raised food prices by paying farmers not to grow crops and to kill off some of their livestock herds instead of bringing them to market. National Industrial Recovery Act (NIRA) reduced unfair competition by letting big corporations collude with each other to keep their prices high. Public Works Administration (PWA) was a whole new agency that built roads and bridges. Works Progress Administration (WPA) paid for more construction work for men, sewing work for women and arts projects for the creatively inclined. National Labor Relations Act (NLRA) gave more power to unions to keep their wages (and the prices of the things they made) high. And many other alphabet agencies.

Most of these programs passed between 1933 and 1935. So FDR put a lot of money into workers’ pockets during the 1930s. And according to Keynesian economics all that money would cause an explosion in consumer spending. Thanks to the Keynesian multiplier. For every dollar a consumer received from the government it would generate up to $5 of new GDP. Which was probably one of the mathematical equations Keynes discussed that so underwhelmed FDR. And that formula is 1/(1-MPC). Where MPC stands for the marginal propensity to consume (and if it’s 0.80 you get a multiplier of 5). If a person receives $100 and spends $80 then their MPC is 0.80 or 80%. This is basically trickle-down economics Keynesian style. If the person above spends that $80 those receiving it will spend $64. Those who receive $64 will spend $51.20. And so on until these other people create an additional $400 of economic activity in addition to that original $100.

And FDR couldn’t ask for a better time to spend that money. During the Great Depression. He was doing everything in his power to increase wages and prices because of the massive deflation of the Great Depression. So even though he was trying to raise prices they were still low throughout much of the economy. Which meant a little bit of money bought a lot of stuff. Because deflation strengthened the dollar. Giving it more purchasing power. Allowing buyers to get a lot of bang for the buck. Especially those union workers making 25% more than they normally would have been making. Talk about kick-starting an economy. It was so easy. They even had mathematical formulas saying this would end the Great Depression. The Great Depression was as good as over.

Had President Obama not been Elected the Great Recession would have Ended some time in 2010

The unemployment rate topped out at around 25% in 1933. Excluding the government make-work, the true unemployment rate didn’t fall below 20% until 1936. And never got below 14% until 1941. When America began tooling up to build the instruments of war. To become the Arsenal of Democracy. A few things happened during this time to greatly reduce the unemployment rate following 1941. The war removed a lot of men from the workforce to serve in the military. The Supreme Court found parts of the New Deal unconstitutional. And there was a split in organized labor that helped conservatives (Republicans and Democrats) gain power in Congress. And they shut down some of those liberal New Deal programs. So while one war began (World War II) another ended (the war on business).

And how did things progress after they ended their war on business? Pretty well. The unemployment rate fell. To 14.6% in 1940. To 9.9% in 1942. To 1.9% in 1943. To 1.2% in 1944. Then it soared back up to 1.9% in 1945. With the war over the unemployment rate rose again. But nowhere near where it was during FDR’s New Deal 1930s. From 1948 to 1968 it averaged 4.7%. Not too bad considering full employment is 5%. So for the 30 years or so following the end of New Deal policies the economy returned to full employment. And stayed at full employment. The conservatives in Congress needed but 4 years to do what FDR couldn’t do in 10 years with his Keynesian, New Deal policies.

Yes, the war helped. A lot. It pulled a lot of men out of the workforce. And American industry ramped up to provide the war material for war. However, we financed that buildup with deficit spending and American war bonds. As most of that war material went to our allies via Lend-Lease. Which means we gave most of it away to allow others to fight the war. So it was little different than Keynesian spending. So why did the war spending work when all those alphabet soup make-work agencies didn’t? Because of the stages of production. Putting more money into consumers’ hands only helped the retail and wholesale stages. It did not do anything to stimulate the manufacturing or raw commodities stages. Especially with those high union wages and lack of competition thanks to the collusion to keep prices high. All that did was pay the very few who actually had jobs very well. While making it economically foolish to hire any new workers because of the exceptionally high cost of labor (25% higher than it would have been without the New Deal programs). That high cost of business just slammed the brakes on economic activity. Economic activity picked back up only after conservatives in Congress undid some of the damage of the New Deal. In fact, had it not been for FDR’s New Deal the Great Depression would have ended some 7 years earlier. Extrapolating this to the Great Recession today one could estimate that the Great Recession would have ended 7 years earlier had it not been for the Keynesian policies of President Obama. So if the current recession lasts as long as the Great Depression and President Obama wins a second term and continues his anti-business policies the recession will last 7 years longer than it need be. Or, had President Obama not been elected it would have ended some time in 2010. Giving us full employment today instead of 14.7% U-6 unemployment.

Fundamental Truth

The Japanese Government made Money Cheap and Plentiful to Borrow creating a Keynesian Dream but an Austrian Nightmare

Once upon a time Americans feared the Japanese. Their awesome might. And their relentless advances. One by one the Japanese added new properties to their international portfolio. They appeared unstoppable. Throughout the Eighties everything was made in Japan. Government partnered with business and formed Japan Inc. And they dominated the world economy in the Eighties. A U.S. Democrat nominee for president held up Japan Inc. as the model to follow. For they had clearly shown how government can make the free market better. Or so this candidate said.

But it didn’t last. Why? Because in the end the Japanese just interfered too much with market forces. Businesses invested in each other. Insulating themselves from the capital markets. Allowing them to make bad investments to sustain bad business planning. All facilitated with cheap credit. Government made money cheap and plentiful to borrow. And they borrowed. A Keynesian dream. But an Austrian nightmare. Because they used that money to make even more bad investments (or ‘malinvestments’ in the vernacular of the Austrian school of economics). Creating a real estate bubble. And a stock market bubble. Bubbles are never good, though. Because they can’t last. They must pop. And when they do it isn’t pretty.

The U.S. just went through real estate bubble that peaked in 2006. Money was so cheap to borrow that people were buying $300,000+ McMansions. Anyone could walk in and get a no-documentation loan with nothing down. People were buying houses and flipping them. And people who couldn’t qualify for a mortgage could get a subprime mortgage. Further pushing house prices higher. Not because of real demand. But because of this artificial tweaking of the free market by the government. Making that money so cheap to borrow. And when all that cheap credit caused inflation elsewhere in the economy the Fed finally tapped the brakes. And increased interest rates. Raising monthly payments on all those subprime mortgages. Leading to a wave of defaults. The subprime mortgage crisis. And the Great Recession.

Japan’s Deflationary Spiral gave American Domestic Manufacturers a Huge Advantage

This is basically what happened in Japan during the Nineties. The government had juiced the economy so much that they grew great big bubbles. Ran up asset prices to incredible heights. But then the bubble burst. And those prices all fell. They fell for so long and so far that Japan suffered a deflationary spiral. Throughout the Nineties (and counting). The Nineties were a painful economic time. After a decade or so of inflation the market corrected that with a decade of recession. And deflation. A decade of economic activity the Japanese just lost. The Lost Decade. But it wasn’t all bad.

At least, in America. There was still some Reaganomics in the American economy. Producing real economic growth. But there was also a bubble. In the stock market. The dot-com bubble. The Internet was brand new and everybody was hoping to be in on the next big thing. The next Microsoft. Or the next Apple. Also, unable (or unwilling) to learn from the mistakes of the Japanese real estate bubble the Clinton administration was making it very uncomfortable for banks to NOT approve mortgage applications for people who were unqualified. Putting more people into houses who couldn’t afford them.

So while the Clinton administration was trying to change America (during the first 2 years they tried to nationalize health care against the will of the people) the economy did well. For awhile. Irrational exuberance was pushing the stock market to new heights as investors poured money into companies that didn’t have a dime of revenue yet. And never would. Clinton had to renege on his promise on the middle class tax cut because things were worse than he thought when he promised to make that middle class tax cut. (Isn’t it always the way that when it comes to tax cuts some politicians can’t keep their promise because they were too stupid to know how bad things really were?) Added into this mix was Japan’s Lost Decade. Their deflationary spiral increased the value of the Yen. And made their exports more expensive. Giving the American domestic manufacturers a huge advantage. The economy boomed during the Nineties. For a mix of reasons. They even projected a budget surplus thanks to the economic woe of the Japanese. But then the dot-com bubble burst. Giving Bill Clinton’s successor a nasty recession.

When a Recession ails you the Best Medicine has been and always will be Reaganomics

The Left always talks about fair trade. And about the unfair practice of foreign manufacturers giving Americans inexpensive goods that they want to buy. So their answer to make these unfair trade practices fair is to slap an import tariff on those inexpensive foreign goods. To protect the domestic manufacturers. For they believe it’s that simple. And plug their ears and sing “la la la” when you discuss David Ricardo’s Comparative Advantage. Ricardo says countries should specialize in the things they’re good at. And import the things others are better at. When everyone does this we use our resources most efficiently. And the overall wealth in the international economy increases. Making the world a better place. And increases our standard of living. But the rent-seekers disagree with this. They want high tariffs. And obstacles for foreign imports. To protect the domestic businesses that can’t sell as inexpensively or at such high levels of quality.

Some would point to Japan’s Lost Decade as proof. Where their deflationary spiral removed a lot of foreign competition to American manufacturing. Allowing them to sell at higher prices and lower quality. All the while protecting American jobs. And, yes, Japan’s woes did help the American domestic manufacturers during the Nineties. But it wasn’t because they could raise prices and lower quality in the face of low foreign competition. It was because there was still enough Reaganomics in the country to produce some vibrant economic activity. That encouraged entrepreneurs to take chances and bring new things to market. Which is a huge difference from the current economic picture.

The Eurozone sovereign debt crisis has plunged Europe into a recessionary freefall. Much like the Japanese suffered in the Nineties. Yet the American domestic manufacturers aren’t benefiting from this huge decline in foreign competition. Why? Because the Obama administration has excised any remaining vestiges of Reaganomics out of the economy. Everything the rent-seekers could ever hope for they have. Only without tariffs. And yet the Obama economy still lingers in recession. Because irrational exuberance and barriers to free trade don’t create real economic growth. And an administration hostile to capitalism doesn’t inspire entrepreneurs to take chances. No. What encourages them to take chances are low taxes. And less costly and less punishing regulations. For programs like Obamacare just scare businesses from hiring any new employees. Because they have no idea the ultimate costs of those new employees.

Now contrast that to the low taxation and relaxed regulatory climate of Reaganomics. That produced solid economic growth. And this growth was BEFORE Japan’s Lost Decade. Which just goes to show you how solid that growth was. And proved David Ricardo’s Comparative Advantage. For both Japan and the United States did well during the Eighties. Unlike Clinton’s economy in the Nineties that only did well because Japan did not. But the good times only lasted until the irrational exuberance of the dot-com bubble brought on an American recession. Which George W. Bush pulled us out of with a little Reaganomics. Tax cuts. Proving yet again that higher taxes and higher regulations don’t create economic activity. Tax cuts do. And fewer regulations. In other words, when a recession ails you the best medicine has been and always will be Reaganomics.

History 101

The New Economic Reality of Farming was that we needed Fewer Farmers in the Age of Mechanization

The Roaring Twenties was a decade of solid, real economic growth. The world modernized during the Twenties. Electric power, telephone, radio, motion pictures, air travel, etc. So much of what we take for granted today became a reality during the Roaring Twenties. But there was a downside. Farmers borrowed money to mechanize their farms. As farms mechanized they produced great crop yields. Bringing bumper crops to market. There was so much food brought to market that prices plummeted. Reducing farm incomes so much that they couldn’t service the debt they incurred to mechanize their farms. They defaulted. Causing banks to fail.

By the late Twenties all the European farmers who fought in World War I were back on the farm. And were feeding Europe again. So not only were the Americans producing bumper crops they were losing a large export market. Forcing farm prices down further. There were simply more farmers than the economy was demanding thanks to the new efficiencies in farming. But because there were so many farmers they were an important political constituency. They were still casting a lot of votes. So the politicians stepped in. With a complete disregard to economic principles. And tried to help the farmers. With rent-seeking policies.

The farmers were hurting. So they wanted to transfer some wealth from the masses to the farmers. As in rent-seeking. As opposed to profit-seeking. Instead of creating wealth (profit-seeking) they were transferring wealth (rent-seeking). And they did this with price supports. They raised the price of their crops above market value. Forcing Americans to make sacrifices in their lives so they could afford to pay higher food prices to help the farmers. So the farmers wouldn’t have to adjust to the new economic reality of farming. We need fewer farmers in the age of mechanization. But it just didn’t end with higher prices. The government would buy excess food grown by these ‘too many farmers’ and destroy it. Or pay farmers NOT to grow food. Then they took it up a notch. And slapped tariffs on imported food. Further raising the price of food.

In an Effort to raise Farming Prices the Rent-Seekers caused the Great Deflation of the Great Depression

Food tariffs were just one part of the Smoot-Hawley Tariff Act. This act pretty much raised the tariff on everything the U.S. imported. Greatly increasing the cost of all imports. To protect the domestic producers from cheap foreign competition. But there was a problem with increasing the cost of all imports. It increased the price of whatever we built with those imports. So much so that when they were discussing this act in Congress businesses across America knew the boom of the Twenties would end. As did investors investing in these companies. So even before the bill became law it caused a huge stock selloff. Which led to the stock market crash of 1929.

At first the higher prices helped American businesses. Their revenue increased. Everyone thought the tariff act was a success. But as prices went up costs went up throughout the manufacturing pipeline. Prices grew so high that people stopped buying. Inventories accumulated so they cut production. And then laid people off en masse. Causing a great recession. Then further rent-seeking solutions (more governmental intervention into the free market) turned that recession into the Great Depression. What started out as a problem for overly efficient farmers turned into a national crisis. In an effort to raise farming prices they caused the great deflation of the Great Depression. As prices fell so did revenues. Making it very difficult to service debt. More people defaulted on their debt. And more banks failed.

When the Smoot-Hawley Tariff Act became law our trading partners answered in kind. Leading to a great trade war. So on top of everything else what limited export markets we had shut down as well. As the trade barriers went up economic activity decreased. David Ricardo’s Comparative Advantage worked in reverse. Increasing opportunity costs. When international markets closed less efficient domestic industries took their place. Pulling resources from more efficient uses. Raising the cost of those resources. Adding these cost increases on top of the tariffs. Which further increased prices. And further lowered economic activity. Adding further woe onto the Great Depression.

The Medallion System dates back to the Medieval Guilds and Restricts Entry into the Cabbie Market

As the Great Depression languished on few people filled the streets of New York City (NYC). At least few people with money who had to go places. There were more cabs than people needed. Supply exceeded demand. Putting a downward pressure on taxi fares. And increasing the time a cabbie had to work to earn some decent money. Usually the market steps in and corrects such a situation. Forcing some cabbies out of the cabbie business. But not in NYC. There they used the power of government to address this surplus of supply. And introduced the medallion system.

This was the kind of rent seeking that dated back to those medieval guilds. The medallion restricted entry into the cabbie market. By limiting the number of cabs in NYC. Every cab (at least those who can pick up passengers who hail a cab at the curb) must have a medallion permanently affixed to their cab. Which they must purchase from the city. Or transfer from another cab. Currently, if you want to drive a taxi cab in NYC you better have some deep pockets. Or have the kind of credit that lets you get a very large mortgage. For the medallion system exists to this day. And that medallion may cost you close to a half million dollars.

If you ever wondered why it sometimes takes so long to hail a cab in NYC this is the reason. Rent-seeking. As in the medallion system. Which works just like tariffs. Reducing supply. And increasing prices for consumers. So the rent-seekers can use the power of government to transfer wealth. Instead of using innovation to create wealth. And bringing that wealth to the market place to trade. Instead they choose to take more wealth from the market place than they bring to it. With the help of government. And their rent-seeking policies. Thus reducing overall wealth in the economy. Which reduces economic activity. And does nothing to help lift an economy out of recession. Or out of a Great Depression.

Economics 101

Inflation is Good for those who Owe Money but Bad for Bankers

There is a direct correlation between the amount of money in circulation and prices. The more money the higher the prices. The less money in circulation the lower the prices. During the Great Depression the Federal Reserve contracted the money supply and prices fell. And it caused havoc in the economy. Low prices a problem? Yes. For some. It was good for anyone buying anything for their money was worth more and could buy more. But it wasn’t good for people who owed money. Or banks.

Farmers had borrowed a lot of money to mechanize their farms in the Twenties. So they owed the banks a lot of money. When prices fell so did their earnings as the crops they grew sold for less at market. Good for the consumer. But bad for the farmer. For with that big ‘pay cut’ they took they could not repay their loans. They defaulted. And when a lot of them defaulted they left banks with a lot of bad loans on the books and little cash in their vaults. Causing bank runs and bank failures.

This is why farmers are in favor of inflation. Increasing the amount of money in circulation. Instead of deflation. Decreasing the amount of money in circulation. For when you increase the money supply prices rise. Meaning more money for them at market. Making it easier for them to repay their loans. For although the money supply increased loan balances remained unchanged. Higher earnings. Same old debt. Therefore easier to pay off. Even though the value of the dollar fell. So inflation is good for the farmer. But bad for the banker. Because the dollars they get back when the farmer repays his loan now buy less than they did before the inflation.

To Fully Appreciate the Impact of Inflation we must talk about Real Prices and Real Wages

Think of a grocer. He buys from a food distributor to stock his grocery store shelves. His distributor buys from farmers and food processing companies. These purchases and sales happen BEFORE a consumer buys anything from a grocery store. Now BEFORE the consumer goes shopping let’s say the Federal Reserve doubles the amount of money in circulation. So the consumer goes shopping with a dollar worth HALF of what it was worth when the grocer stocked his shelves. So if the grocer doesn’t raise his prices to account for this inflation he’ll be able to replace only HALF of what he sells with the proceeds from those sales. Because his distributors will have doubled their prices to reflect the halving of the value of the dollar.

Of course doubling prices throughout the food supply chain will ultimately lower sales. Which no one in this chain wants. Which creates somewhat of a problem. Especially when consumers don’t like paying higher prices. Food processing companies will raise their prices. But they can do something else to make it look like they’re not raising their prices that much. They can reduce their packaging. So boxes of cereal and bags of chips get smaller while prices increase only a little. This lessens the perception of inflation on both consumer and seller. At least, for those who can do this. We sell gasoline by the gallon. Which means they have to pass on the full impact of inflation in the price at the pump. Which makes it look like gasoline prices are rising faster than most other prices. Which is why consumers hate oil companies more than food companies.

The price we pay in the grocery store and at the pump are nominal prices. Prices noted in dollars. Nominal prices rise to factor in inflation. But they don’t tell us the real impact of inflation. That is, how it reduces our purchasing power. For prices aren’t the only thing that rise. Our wages do, too. And if our nominal wages rise at the same rate as nominal prices do we won’t really notice a difference in our purchasing power. If our nominal wages rise faster than nominal prices then we gain purchasing power. If nominal prices rise faster than our nominal wages we lose purchasing power. So to fully appreciate the impact of inflation we must talk about real prices and real wages. Not the dollar amount on the price tag. But the affect on our purchasing power. In times of increasing purchasing power a single earner may be able to meet all the financial needs of a family. In times of declining purchasing power it may take a second income to meet the financial needs of the family. This is what we mean when we talk about real prices and real wages.

Government causes the Erosion of Purchasing Power Always and Everywhere

You may get a large raise at work giving you a high nominal wage. But if nominal prices are rising (as in a higher price at the gas pump) real wages are falling. Because you can’t buy as much as you once did. Meaning you’ve lost purchasing power. So even though you got a nominal raise you may have taken a real pay cut. Pretty much everyone today earns more than their father did. Yet today we struggle to have as much as our fathers did. Even with a second income in the family. This is the impact of inflation. Which causes real prices to rise. Real wages to fall. And our standard of living to fall.

As real prices rise and real wages fall we have to make choices. We can’t have the same things we once did. If we lose too much purchasing power our spouse may have to provide a second income, spending less time with his or her children. Or people may work more overtime. Or take a second job. Or simply cut back on things. And enjoy life less. Cut out movie night. Or going out to dinner. Not renew their season tickets. Or give less to charity. This is the true cost of inflation.

This all goes back to the amount of money in circulation. As Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” Meaning that only government can create inflation. Because government controls monetary policy. And the amount of money in circulation. Which means government causes the erosion of purchasing power always and everywhere. Even the price at the pump. As oil is a global commodity priced nominally in U.S. dollars. So whenever the Americans inflate their money supply the oil producers raise their prices to offset the devalued U.S. dollar. So government causes much of the pain at the pump. Whose monetary policies decrease real wages. And increase real prices.

History 101

Nations abandoned the Gold Standard to Borrow and Print Money freely to pay for World War I

Banks loan to each other. They participate in a banking system that moves capital from those who have it to those who need it. It’s a good system. And a system that works. Providing businesses and entrepreneurs with the capital to expand their businesses. And create jobs. As long as all the banks in the system go about their business responsibly. And their governments go about their business responsibly. Sadly, neither always does.

World War I changed the world in so many ways for the worse. It killed a generation of Europeans. Bankrupted nations. Redrew the borders in Europe as the victors divvied up the spoils of war. Setting the stage for future political unrest. Gave us Keynesian economics. Saw the beginning of the decline of the gold standard. A deterioration of international trade. A rise of protectionism and nationalism. Punishing German reparations. To pay for a war that they didn’t necessarily start. Nor did they necessarily lose. Which created a lot of anger in Germany. And provided the seed for the Great Depression.

A set of entangling treaties brought nations eagerly into World War I. There was great patriotic fervor. And a belief that this war would be Napoleonic. Some glorious battles. With the victors negotiating a favorable peace. Sadly, no one learned the lessons of the Crimean War (1853-1856). Which killed approximately 600,000 (about 35% of those in uniform). Or the American Civil War (1861-1865). Which killed approximately 600,000 (about 20% of those in uniform). The first modern wars. Where the technology was ahead of the Napoleonic tactics of the day. Modern rifled weapons made accurate killing weapons. And the telegraph and the railroads allowed the combatants to rush ever more men into the fire of those accurate killing weapons. These are the lessons they didn’t learn. Which was a pity. Because the weapons were much more lethal in World War I (1914-1918). And far more advanced than the tactics of the day. Which were still largely Napoleonic. Mass men on the field of battle. Fire and advance. And close with the bayonet. Which they did in World War I. And these soldiers advanced into the withering fire of the new machine gun. While artillery rounds fell around them. Making big holes and throwing shredded shrapnel through flesh and bone. WWI killed approximately 10,000,000 (about 15% of those in uniform). And wounded another 20 million. To do that kind of damage costs a lot of money. Big money. For bullets, shells, rifles, artillery, machine guns, warships, planes, etc., don’t grow on trees. Which is why all nations (except the U.S.) went off of the gold standard to pay for this war. To shake off any constraints to their ability to raise the money to wage war. To let them borrow and print as much as they wanted. Despite the effect that would have on their currency. Or on foreign exchange rates.

As Countries abandoned the Gold Standard they depreciated their Currencies and wiped out People’s Life Savings

Well, the war had all but bankrupted the combatants. They had huge debts and inflated currencies. Large trade deficits. And surpluses. A great imbalance of trade. And it was in this environment that they restored some measure of a gold standard. Which wasn’t quite standard. As the different nations adopted different exchange rates. But they moved to get their financial houses back in order. And the first order of business was to address those large debts. And the ‘victors’ decided to squeeze Germany to pay some of that debt off. Hence those punishing reparations. Which the victors wanted in gold. Or foreign currency. Which made it difficult for Germany to return to the gold standard. As the victors had taken most of her gold. And so began the hyperinflation. As the Germans printed Marks to trade for foreign currency. Of course we know what happened next. They devalued the Mark so much that it took wheelbarrows full of them to buy their groceries. And to exchange for foreign currency.

Elsewhere, in the new Europe that emerged from WWI, there was a growth in regional banking. Savvy bankers who were pretty good at risk evaluation. Who were close to the borrowers. And informed. Allowing them to write good loans. Meanwhile, the old institutions were carrying on as if it was still 1914. Not quite as savvy. And making bad loans. The ones the more savvy bankers refused to write. Weak banking regulation helped facilitate these bad lending practices. Leaving a lot of banks with weak balance sheets. Add in the hyperinflation. Heavy debts. Higher taxes (to reduce those debts). Trade imbalances. And you get a bad economy. Where businesses were struggling to service their debt. With many defaulting. As a smaller bank failed a bigger bank would absorb it. Bad loans and all. Including an Austrian bank. A pretty big one at that. The largest in Austria. Credit-Anstalt. Which was ‘too big to fail’. But failed anyway. And when it did the collapse was heard around the world.

As banks failed the money supply contracted. Causing a liquidity crisis. And deflation (less money chasing the same amount of goods). Currency appreciation (further hurting a country’s balance of trade). And low prices. Which made it harder for borrowers to service their debt with the lower revenue they earned on those lower prices. So there were more loan defaults. Bank runs. And bank failures. Spreading the contagion to Amsterdam. To Warsaw. Germany. Latvia. Turkey. Egypt. Britain. Even the U.S. Soon countries abandoned the gold standard. So they could print money to save the banks. Lower interest rates. Depreciate their currencies. And wipe out large swathes of wealth denominated in that now depreciated currency. What we call Keynesian policies. People’s life savings became a fraction of what they were. Making for a longer working life. And a more Spartan retirement.

Abandoning the Gold Standard didn’t fix the U.S. Economy in 1971

Meanwhile in the U.S. the government was destroying the U.S. economy. Trying to protect domestic prices they passed the Smoot-Hawley Tariff. Raising the price for businesses and consumers alike. And kicking off a trade war. Both of which greatly reduced U.S. exports. New labor legislation keeping wages above market prices while all other prices were falling. And higher taxes to pay for New Deal social programs. Wiping out business profits and causing massive unemployment. Then came the fall in farm prices due to increased farm productivity. Thanks to farmers mechanizing their farms and greatly increasing their harvests. Thus lowering prices. Making it hard to service the bank loans they got to pay for that mechanization. Thus leading to bank failures in the farming regions. That spread to the cities. Causing a liquidity crisis. And deflation.

Then came Credit-Anstalt. And all the woe that followed. Which caused a speculative run in Britain. Which made the British decide to leave the gold standard. To stem the flow of gold out of their country. Which destroyed whatever confidence was still remaining in their banking system. People thought that the U.S. would be next. But the Americans defended the dollar. And instead raised interest rates (by reducing the money supply). To keep the dollar valuable. And to protect the exchange rate. Making it less attractive to exchange cash for gold. And to restore confidence in the banking system. Of course, this didn’t help the liquidity crisis. Which Keynesians blame for the length and the severity of the Great Depression.

Of course, it wasn’t the gold standard that caused the fall of Credit-Anstalt. It was poor lending practices. A weak banking regulation that allowed those poor lending practices. And a lot of bad government policy throughout Europe. Especially those punishing German reparations. And the gold standard didn’t cause the economic collapse in the United States. For it worked well the previous decade. Providing all the capital required to produce the Roaring Twenties that modernized the world. It was government and their intrusive policies into the free market that caused the economic collapse. And abandoning the gold standard wouldn’t have changed that. Or made the economy better. And we know this because leaving the gold standard didn’t solve all of the countries woes in 1971. Because the government was still implementing bad Keynesian policies.